If you own an international fund or if you sold some shares last year, don't let Uncle Sam take a nickel more than necessary.
Part of being a smart mutual-fund investor is making sure you walk away with as much profit in your pocket as possible. This means avoiding load funds (usually anyway) and funds with ridiculously high expense ratios. Now, most readers are aware of these pitfalls, but one area where many wise fund investors still stumble is with taxes. For starters, many investors don't pay close enough attention to a fund's tax efficiency. And that isn't the only common mistake. Here are a couple more often-overlooked ways to reduce the tax hit to your fund shares:
No. 1: Are You Invested in Foreign Stocks or Mutual Funds?
If you've worked in a foreign country or have substantial income from outside the U.S., you probably know all about the foreign tax credit. It's intended to keep you from being taxed on the same income by two different countries. But if you simply invested in some international mutual funds, you may also be able to claim this valuable tax break since it's quite likely you paid foreign taxes last year (even though you probably didn't know it).
To find out, take a close look at your fund summary statements for the previous tax year. You will probably have to make some calculations to figure the exact amount of foreign taxes that came out of your account. Fortunately, your fund family should provide you with the information you need to do the math. (Usually they will give you a figure by which you'll multiply the number of shares you own.) The payoff is that you're allowed a dollar-for-dollar credit against your U.S. income-tax bill. So while this might seem like a hassle, the extra work is definitely worth the trouble.
If you have direct holdings in foreign stocks or bonds, any foreign taxes should show up on your Forms 1099-DIV and 1099-INT. Assuming that (1) all your foreign taxes were on interest and dividends (including those earned via mutual funds), and (2) the foreign taxes amounted to $300 or less ($600 if you file jointly), things are simple. Just claim your credit by entering the foreign tax amount on Form 1040, Line 43. In all other cases, you must file Form 1116 (Foreign Tax Credit) to claim your rightful credit. Consider yourself warned: This form is pretty nasty, so you may want to get professional assistance if your foreign tax hit was substantial.
No. 2: Did You Sell Fund Shares Last Year?
If you've invested in a mutual fund, chances are you agreed to automatically reinvest all your dividends to buy more shares in the same fund. After all, it's a pretty painless way to dollar-cost average into a fund. But if you sold some shares last year, don't forget to claim the additional basis from the reinvested dividends in calculating your gain or loss on Schedule D. In other words, because you paid tax on those dividends (even though the cash never actually passed through your hands), the reinvested amounts represent after-tax dollars in the form of additional share basis.
For example, say a few years ago you invested an initial $2,000 to buy 100 shares in Fund XYZ. During your ownership period, you received a total of $500 in dividends, which were automatically reinvested to buy 20 more shares of the fund. Then last year, you sold your shares. In figuring your gain or loss, the correct tax-basis figure for your 120 shares is $2,500 (your $2,000 initial investment plus the $500 reinvested to acquire additional shares). If you screw up and claim only $2,000 of basis, you'll overstate your gain or understate your loss by $500. Then IRS gets more than it should, and you lose out.
Now, your fund company should have provided you with your average basis for all the shares you own, including those acquired by reinvesting dividends. But many investors still overlook this information and use their own (incorrect) figures. So do yourself a favor and take a close look at the year-end statement from your fund family.